BIDU

Over the past few years, I have been a consistent bull on Baidu.com (BIDU), which has served me quite well on a number of occasions. However, as a number of new risks have emerged at the worst possible time, I am now turning very bearish on the share price going forward. Over the medium term (6 months to 1 year), I am moderately bearish, but in the near term, I am significantly more bearish and see the share price potentially breaking through the $70.00 level.

As for the positives, Baidu continues to occupy a dominant place in the Chinese internet space, and at any price below $100, it appears to be exceedingly cheap for a number of good reasons. The company has a formidable ROI of over 40% and net marginswhich are still roughly 50%. The only criticisms that analysts can find with Baidu are that revenue is not growing at the scotching clip that it had in the past as well as the potential for further slowdowns as Qihoo 360 (QIHU) continues to make progress in the market for online search at a surprisingly rapid pace.

However, there are several macro and micro risks to the share price which could send the share price sharply lower, and at a minimum these concerns will almost certainly put a cap on the share price at current levels. In the vast majority of articles, authors speak extensively about all of the strong fundamentals that can be found in Baidu, and I agree with their sentiments in this area entirely. The problem is that in overly focusing on the easy to analyze (and positive) quantitative elements, these authors make little to no mention of the harder to analyze (and negative) qualitativerisksthat clearly dominate the equation in a massive way. In short, they are completely ignoring the factors that are by far the most important in determining where Baidu will trade in the near future. Recent examples include:

Each of these concerns would not be nearly as significant if they occurred in isolation. The problem for Baidu is that all of these problems are coming to a head at the same time. And with the stock now brushing on multi-year lows, the temptation to harvest significant tax losses to offset taxable gains on better performing stocks will be very strong during the next 2 weeks.

The SEC and VIE issues obviously apply very broadly to many Chinese stocks. However, the last 3 issues are very specific to Baidu. Given the rise in Baidu’s share price over the past few days, it appears that many investors are demonstrating very short memories with regards to concerns in the past and are likely being distracted by micro news which could easily be overshadowed. Each of these concerns is discussed below.

Concerns over SEC / audit risk

The SEC and VIE risks are equally applicable to all of the Chinese internet stocks, including Sina (SINA), Yoku.com (YOKU), RenRen (RENN) and Qihoo 360 . Selected other non-internet stocks can also be included in this group such as New Oriental Education (EDU). With the SEC issue and the VIE issue, investors are again showing how quickly they forget about significant problems as soon as some small, positive piece of new information arrives. In both cases, the SEC and VIE issues have not dissipated in any way.

News of the SEC’s interest in inspecting the audit files of the China-based arms of auditors hit during the week of November 26th and there was minimal reaction. But then the SEC released its administrative order against Ernst & Young, KPMG, Deloitte, PWC and BDO on December 3rd. This group of “Big 4” plus one audit the majority of Chinese stocks that trade in the US. Baidu had already traded as low as $91 in the previous week, which many viewed as a compelling buy opportunity. The stock rose as high as $99, but when the SEC’s order came out, Baidu quickly dropped to a multi-year low of $85.96.

Some investors have come to the conclusion that if Baidu does not have any accounting problems itself, then there should be little risk of a closer eventual look by the SEC into the audit papers of its auditor E&Y. This is not the case.

As most China focused investors have become aware, there is a significant contagion problem when investing in Chinese stocks. In 2011, a large number of smaller cap Chinese stocks failed their audits and were delisted. This fact alone took down many other stocks which had no audit issues of their own.

More recently, in July when New Oriental announced that the SEC was inquiring into details of its VIE structure, all other VIE stocks took an immediate and substantial dive. At the time, BIDU had been trading at around $110 before suddenly dipping below $100 for the first time in years.

The point is that even if Baidu has no accounting issues of its own, if a closer look by the SEC reveals any problems at anyother US listed Chinese internet company, then we can be sure that Baidu’s share price will be significantly affected.

Of equal concern is the fact that the stalemate between auditors and the SEC is in no way resolved and looks like it will escalate into a significant confrontation.

In response to the SEC administrative order, PWC issued the following statement:

Today’s action by the U.S. Securities and Exchange Commission is the result of conflicting laws between the U.S. and China. The fact that the action is being taken collectively against all of the four largest audit firms and one other firm demonstrates that this is a profession-wide issue, not unique to one firm. For its part, PwC China has cooperated with the SEC at every opportunity.

However, PwC China will, and must, comply with its legal obligations under China law. This action involves an issue that needs to be resolved between the US and China regulators as it impacts all audit firms in China serving clients who are registered with the SEC. PwC China hopes for continuing dialogue between those two parties to resolve the matter.

So clearly resolution of this issue is going nowhere fast. However, in the US capital markets, the auditors are not on equal footing with the SEC. The SEC makes the rules and the auditors are supposed to play by them. The clear risk here is that the SEC may choose to implement a temporary solution to the problem as it waits for cooperation from the Chinese government which may never come. Investors will have no idea what this temporary solution may be or when it will come until the SEC announces it, and the effect will once again be significantly detrimental to Baidu and other US listed Chinese stocks.

Concerns over the VIE structure

The problems associated with VIE structures have been discussedoff and on for a few years, but received the most attention back in July when New Oriental revealed that the SEC was looking into the details of its VIE structure. It continues to surprise me how many investors, including large institutional fund managers, have no idea what the implications are when owning a VIE stock.

VIE stands for “variable interest entity” and it means that the shareholders of the company have no claim on the underlying assets of the company, which is entirely contrary to the very concept of owning stock in the first place. The reason for this odd structure is that certain industries in China (such as internet and education) are considered to be protected and sensitive industries and foreigners are not allowed to own them. To work around this, US bankers developed a structure whereby investors own shares in an offshore (usually Cayman) company whose sole asset is a contract with the underlying company which gives them a contractual right to the earnings of the company. The ability to enforce this contract has not really been tested and remains unclear.

What this means for investors is that if anything goes wrong and the company spirals downward in value, there is no real floor to the stock because no white the likes of Warren Buffett will come in and acquire the entire company to gain access to its assets. Buying the whole company is useless because what you would really be buying is just the shares in a Cayman Islands company whose sole asset is an unenforceable contract.

As investors woke up to this reality in July, Baidu fell below $100 for the first time in years. Yet within a few months the stock rose to as high as $135. Investors simply forgot about the fact that they owned nothing due to impressive earnings from Baidu in August. It is quite literally the case that Baidu could discover oil beneath their headquarters in Beijing and it would deliver no legal value to Baidu shareholders, so it is notably odd that better than expected earnings would cause some investors to temporarily forget their previous concerns over the VIE structure. That doesn’t mean Baidu should be sitting at zero, it just means that the valuation should be discounted accordingly. At a price of $135, there was clearly no discounting taking place, nor is there at a price of $95.

Concerns over an expected acquisition

In August, Baidu raised $1.5 billion in a bond deal directed at US investors. Baidu already has over $3 billion of cash on its books and that cash balance has been growing at a rate of around $500 million per quarter. Clearly, Baidu doesn’t need money for continuing operations so most investors are expecting anacquisition. The most obvious target would be a company which can help Baidu ward off the invasion by Qihoo into the internet search space.

A good acquisition could help to allay investors’ concerns over Baidu’s slowing revenue growth due to Qihoo. However, any acquisition that is perceived as being only marginally beneficial or even over payment for a better acquisition could also hit the shares hard.

Baidu has the technical and financial resources to embark on a variety of business improving projects, so the perception that Baidu must go out of house to rejuvenate its business has raised concerns over management’s ability to identify and implement solutions on its own.

In addition, large internet companies have a less than impressive track record of integrating their target companies as planned and overpayment for acquisitions is very common.

This issue would clearly be less of a concern absent the other issues, but with Baidu facing a number of headwinds from multiple directions, a less than optimal acquisition will be very poorly received by investors.

Concerns over growing Qihoo threat

In April, I had voiced a number of concerns regarding Qihoo 360 and I felt that there was even some risk that Qihoo might face problems in its upcoming audit by Deloitte. Three weeks later, Qihoo passed its audit without issue and it was back to business as usual. In June I sat down with Qihoo CEO Zhou Hong Yi in his office in Beijing for a 2 hour chat. Our chat was extremely interesting, and contrary to his public persona as the “mad dog” of the Chinese internet, he was exceedingly personable. We spent very little time discussing past issues as Mr. Zhou was primarily focused on telling me about Qihoo’s future. I had been asking a number of questions about mobile applications, which is where I expected him to tell me that Qihoo’s future revenue growth was going to come from. Instead, all Mr. Zhou wanted to talk about was Qihoo’s future in search. At the time, I largely dismissed his ambitions in this area due to my perception that Baidu’s dominance was unassailable. He did talk a very good game though and I left his office with the distinct impression that Mr. Zhou was an individual who can clearly “talk the talk.”

Just 8 week later, Mr. Zhou demonstrated that he can also “walk the walk” when Qihoo announced that it had already captured 5-10% of the search market, which we all know had to come at the direct expense of Baidu. Baidu’s shares took an immediate tumble in August, and then tumbled again in November when Qihoo announced even more progress and search and a new initiative to launch a music service in competition with Baidu.

A year ago Qihoo was notably overvalued. Now, the share price has risen slightly but Qihoo has quickly grown into its valuation. Qihoo now has nearly $400 million in cash and is profitable in a meaningful way. With a presence built into the computers of a few hundred million Chinese internet users, Qihoo has a notable advantage over Baidu in aggregating information from users as well as their preferences for a wide variety of applications.

Baidu is still in the dominant position by a very wide margin when it comes to search. It is not the level of threat from Qihoo that is concerning, but instead it is the very rapid rate with which Qihoo is making progress that is concerning. In addition, Qihoo has already demonstrated that it is willing to take the fight to Baidu in multiple arenas, including search, mobile and music.

So far these inroads have been large relative to Qihoo’s history, but small relative to Baidu’s dominance. I am currently expecting that Qihoo will hit a major tipping point in tacking Baidu either in Q4 2012 or in Q1 2013. As soon as Qihoo hits the 20% mark, concern among Baidu shareholders will become far more noticeable.

China’s internet space is certainly big enough for two large players and at the current share prices both Baidu and Qihoo would be considered a strong buy. However, both of these stocks share the same risk factors with respect to the SEC / audit issue and the VIE issue. As a result, at a minimum, the share prices are likely to see their movements capped in the near term. The problem for Baidu is that it is falling from a position of strength while Qihoo is rising from (formerly) of no position at all.

Concerns over significant tax-loss selling in December

Once again, comparing Baidu to Qihoo is instructive. Qihoo is currently trading at around $25.00, which is near its 52-week high of $28.16, reached just last week. Qihoo is up from a 2012 low of $13.95 which means that anyone who bought Qihoo during the course of 2012 is likely up on their investment and has no tax motivation for selling.

By contrast, Baidu has a very ugly chart which is likely to incentivize substantial tax loss selling in December. Baidu began the year at $125 and reached a high of over $150 in April. Prior to November, the stock only briefly traded below $100 following the New Oriental fallout. However, it has now been over 1 month since Baidu closed above $100 and it looks unlikely to be able to break this key barrier in the near future. As a result, and unlike Qihoo, virtually 100% of investors who bought into Baidu before November are now sitting on losses of as much as 30-40%. The only reason to not sell Baidu in December for the tax benefit would be if Baidu was expected to soar in Q1 2013. Given the number of other concerns and the magnitude of these concerns this is highly unlikely, so tax selling makes the most sense for investors who are underwater on Baidu.

Conclusions

After seeing the stock trade north of $130 for much of its recent life, predicting a stock price at or below $70 may seem aggressive. However, looking at the fate of Sina shows that this is an entirely realistic scenario. For a long time, Sina was an internet darling in China. Sina peaked out at $140 in 2011 before hitting a rough patch and quickly trading down to around $70-80 per share. At that time Sina’s twitter-like Weibo service was just hitting a positive tipping point, as were the prospects for its profitability. Unlike Baidu, Sina has struggled with profitability, although revenues continue to grow sharply each quarter. Despite this, Sina continued downward to below $50 by the end of 2012 before rebounding to a 2012 high of $80 again. Last week Sina looked set to now break below the $40 range, and only a reported relaxing of government controls on Weibo has pushed it up this week. Over the past few days Baidu has risen on the back of the rise in Sina simply due to the fact that China internet stocks trade as a sector and not on the back of any significant positive developments for Baidu. In fact, both Sina and Baidu share the same big picture risks. However, it is simply the case that Sina has already fallen so much further than Baidu that some bottom fishing may be perceived as understandable. In fact, both stocks still face substantial downside risk as well a strong headwinds against meaningful appreciation before year end.

Personally, I have developed a bit of a negative bias against Baidu following the work I did while looking into Qihoo some months back. I was trying to find a comparison point to evaluate Qihoo’s advertising revenues on its web portal hao.360.cn. The most obvious point of comparison would be Baidu’s hao123.comwhich is nearly identical in all respects. Despite a widespreadrumor that Baidu’s hao123 would account for over 20% of Baidu’s profit, Baidu consistently refused to break out this segment of its business and I saw no reason to not simply disclose it. I made numerous attempts to speak with Baidu’s CFO, all of which were rebuffed for the simple reason that she was “too busy” to speak with a shareholder who writes extensively on Chinese stocks and who has been consistently positive on Baidu. I have had in person meetings with senior management at over 100 public Chinese companies, yet with Baidu by the end I found myself begging for just 10 minutes of time on the phone and I couldn’t even get that. I was able to speak with Baidu’s investor relations department, but as is often the case with many companies, IR’s answers typically consisted of “I don’t know” or “we don’t disclose that,” making for several very unproductive conversations. Even over the past year when my views on most Chinese stocks have been negative and short focused, I have still been able to get meetings with senior management at every company in which I have had an interest, with the exception of only Baidu. Also, ultimately I was able to go through various other means and sources to find out that the 20% rumor was dead wrong and that hao123 contributes well under 5% to Baidu’s bottom line.

I found this experience with Baidu to be particularly troubling in comparison to my experience with Qihoo. With Qihoo I had been a constant skeptic and critic for nearly a year and I had often been short the stock and been vocal about my negative views. Yet I was able to have more than 5 conversations with Qihoo’s CFO Alex Xu who even gave me his cell phone number and took my calls on the weekend. If he bore any grudge against my negative views, it certainly was not evident from my discussion with him and I felt I was treated the same as would be any long shareholder. One of my articles on Qihoo received considerable attention before their audit, enough for them to issue a written response. Yet a few weeks later I was able to sit down with Qihoo CEO Zhou Hong Yi in his office in Beijing and spend 2 hours talking about Qihoo’s future. For reference, Zhou Hong Yi is the CEO of a $3 billion NYSE listed company and he is roughly a billionaire himself, so I had not expected to get this much of his time, especially on short notice.

Initially, I had concluded that Baidu was simply guilty of some (perhaps semi-deserved) arrogance due to their dominant position in the China internet space and the size of their company, which was as the time over $40 billion in market cap.

That might very well be the case, however as I discussed my disappointment in Baidu with a number of institutional investors in Beijing, I found that the response was quite consistent regardless of who I spoke to. Investors describe Baidu as a “black box” because the company achieves spectacular results without always breaking out the key information which would better explain those results. This is something that always makes me uncomfortable and I have gotten the impression that many other investors have not been successful in having a dialogue with Baidu either. As with all investments, investors have a choice with Baidu as to whether to hit “buy” or “sell” on any given day, and as we can see from the stock price, more investors are hitting sell than buy, pushing the stock to multi year lows. Regardless of whether it is corporate arrogance or a resistance to disclose information, Baidu is now no longer in a position to be practicing either given that its share price has fallen precipitously and it is under attack by a competitor.

Based on all of these points, I am now short Baidu. The short thesis is pretty easy for Baidu, even given its omnipresence in the Chinese internet world, its dominance in search and its strong fundamentals. The short thesis is simply that there are many factors which could send Baidu sharply lower, but basically none which could send it sharply higher. The only risk in the near term is that the stock does nothing and stays flat or only declines by a moderate 5-10%.

The SEC risk, the VIE concerns and the uncertainties over Baidu’s ability to sustain its wide lead in the space may or may not cause a more meaningful drop in the stock in the next 2 weeks. But in any event, these concerns are almost certain to prevent a substantial rise in the stock. Over the longer term, Baidu’s much suspected acquisition will be very important. If they get it right, it could help the stock to some extent. But if they get it even slightly wrong or overpay for it, then the share price will certainly suffer.

The only real catalyst for Baidu to rise would obviously be some clarity out of the SEC regarding its issues with audits and VIE structures. However given that this process involves cooperation between the SEC, the auditors and the Chinese government, any progress will undoubtedly take a minimum of a few months. By that time, we start entering audit season for 20F filers, which comprises all of the Chinese internet names. Many investors (myself included) simply refuse to hold any Chinese stocks during audit season. This is simply due to the contagion problem which has shown that even if any given company has no accounting issues itself, a problem in any other related company will have a significant impact on the share prices of their entire peer group.

The point of this last observation is simply that Baidu shares have the risk of significant downside in the near term, but no real catalyst for upside until the audit season ends in May.